Principles of Accounting- Statement of Cash Flows

7/17/2006 Nguyễn Tấn Bình 3The main objective of the statement of cash flows • Shows the relationship between the Net Income and Net Cash Flow • Explains how cash is generated and used

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The main objective of the statement of cash flows

• Shows the relationship between the Net

Income and Net Cash Flow

• Explains how cash is generated and used

during a business period

• Evaluates the ability to pay debt in time

• This information is very useful to decision makers (managers, lenders, shareholders…)

in forecasting the future cash flows

The necessity of the statement of cash flows

Additionally provides a lot of important information that the balance sheet and the income statement cannot to provide:

• The balance sheet only reflects the values and the

sources of assets at a certain date (a point of time)

9 How to know how much the firm has disbursed for purchases (or collected from liquidations) of fixed assets during a business period?

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The necessity of the statement of cash flows

Additionally provides a lot of important information that the balance sheet and the income statement fail to provide:

• The income statement is made on the accrual, not

the cash, basis of accounting

9 Why does a firm show profit but have no cash, and vice versa?

9 How to explain changes (increases or decreases) in cash balance from the beginning to the end of the business period?

What is called “cash” in the

statement of cash flows

• Cash, bank deposits, floats, and cash equivalent securities

• Cash equivalent securities include

– Marketable securities with high liquidity– Easy to be transferred into cash

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Classification of cash flows

A firm of any form or any size has 3 types of

activities:

1 Operating

2 Investing

3 Financing The statement of cash flows reflects three cash flows from the three above activities

Cash flow from operating

• Disbursement flows into and receipt flows from the main operating activity of the firm

• There are two methods to calculate the cash flow from operating activity:

– Direct method – Indirect method

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Cash flow from operating

Receipt flows (inflows) include:

– Collections from customers – Interest receipt, receipt from other operations

– Dividend receipt (from investments in other companies)

Cash flow from operating

Disbursement flows (outflows) include

– Payment to suppliers – Interest, tax payments – Salary payment

– Payment to other operations Pa

o t

or de

r o f

financing: the direct method

• Shows the actual disbursement and receipt flows

Cash flow from investing

• Disbursement and receipt flows for purchases and sales of fixed assets, investments, and investment recovery

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Cash flow from investing

• Receipt flows (inflows) include

– Liquidations of fixed assets – Sales of marketable

securities – Recovery of investment or lending

• Disbursement flows (outflows) include

– Purchases of fixed assets – Purchases of marketable securities

– Lending or capital contribution to other companies

Cash flow from investing

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• Disbursement flows into and receipt flows from financing activity (capital mobilization) for the firm’s operations

• Funds raised from owners and

lenders

Cash flow from financing

• Receipt flows (inflows) include

– Stock issue – Corporate bond issue – Bank loans

Cash flow from financing

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• Disbursement flows (outflows) include

– Repurchases of stock (treasury stock)

– Recall or payment of corporate bond

– Debt payment – Dividend payment

Cash flow from financing

Non-cash investing and financing

activities

Example:

– Debt-equity conversion – Purchases and sales of fixed assets on credit

• These activities do not generate cash flows, hence, are not shown on the statement of cash flows

• However, the endnotes to the statement of cash flows or a separate statement is prepared to explain their changes on the balance sheet

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Some common transactions and their

impacts on the cash flows

Operating transactions

• Sales of goods/services for cash +

• Interest receipt from investments +

• Collections from accounts receivable +

• Record of cost of goods sold 0

• Inventory purchases for cash

• Payment for accounts payable

-Some common transactions and their impacts on the cash flows (cont.)

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Some common transactions and their impacts on the cash flows (cont.)

Financing transactions

• Purchases of fixed assets for cash

-• Purchases of fixed assets on account 0

• Liquidations of assets for cash +

• Sales of fixed assets on credit 0

• Purchases of marketable securities

-• Sales of marketable securities +

-Some common transactions and their impacts on the cash flow (cont.)

Financing transactions

• Borrowing (long and short term) +

• Debt payment (long and short term)

-• Stock issue (common and preferred) +

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Cash flow concept

Conventions on cash flows:

ƒ Inflows, or receipt flows

ƒ Outflows, or disbursement flows

Total net cash flows (from three activities) equal the difference between ending and beginning cash balances Net Cash Flows = Inflows – Outflows

Cash flow concept (cont.)

Total net cash flows (from three activities) equal the

difference between ending and beginning cash balances

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Preparing the statement of cash flows

A statement of cash flow includes three parts

Net cash flow from operating (I)Net cash flow from investing (II)Net cash flow from financing (III)Total net cash flows = I + II + III+ Beginning cash balance

= Ending cash balance

Two methods

of preparing the statement of cash flows

(for net cash flows from operating)

Indirect method

– Net cash flow from operating is calculated by

adjusting from net income

– Most of companies use this method

Direct method

– Net cash flow from operating is calculated from

actual receipt and disbursement flows

– This method is comprehensible to readers, but few companies use it Discussion

Direct method

• The simple direct method uses accounting books

such as ledgers and cash book to pick up the receipt and disbursement flows However, the workload is troublesome, confusing, and infeasible

– Cash book is recorded in chronologic order, while the statement of cash flows classifies cash flows into various activities (operating, investing, and financing)

– How can outsiders have this book?

• This lecture presents the inferential direct method,

Revenues - (Ending – Beginning) Accounts Receivable = Receipts

A numeric example of revenues

BBB Company

• Beginning-of-year Receivables (1/1/2004) are 4,000

• Ending-of-year Receivables (31/12/2004) are 5,000

• Revenues during 2004 are 80,000

– What are the accrual receipts?

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A numeric example of revenues

InterpretationCustomers owe 4,000 at the beginning of the year; they owe an additional amount of 1,000 during the year; they owe 5,000 at the end of the year

The difference (ending – beginning balance) is the credit amount accrued (+), or paid (-) during the period

Here, (ending – beginning balance) = 5,000 – 4,000 = 1,000

BBB Company

• Beginning-of-year Receivables (1/1/2004) are 4,000

• Ending-of-year Receivables (31/12/2004) are 5,000

– What are the accrual receipts?

A numeric example of revenues

InterpretationRevenues are 80,000 during the year The firm thus collects 79,000 because customers owe additionally 1,000 during the period

Accrual collections from customers are :

BBB Company

• Beginning-of-year Receivables (1/1/2004) are 4,000

• Ending-of-year Receivables (31/12/2004) are 5,000

– What are the accrual receipts?

Expenses - (Ending - Beginning) Expenses Payable = Disbursements

A numeric example of expenses

BBB Company

• Salaries expense accrued during 2004 is 2,000

• Salaries payable at the beginning of the year (1/1/2004) are 200

• Salaries payable at the end of the year (31/12/2004) are 100

What is the amount paid as salaries?

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A numeric example of expenses

InterpretationThe firm owes employees 200 at the beginning of the year;

it pays 100 during the year; so it still owes 100 at the end

of the yearThe difference (ending ending– beginning balance) is the amount paid (-) during the year

In our example, ending balance – beginning balance = 100 – 200 = -100

BBB Company

• Salaries expense accrued during 2004 is 2,000

• Salaries payable at the beginning of the year (1/1/2004) are 200

• Salaries payable at the end of the year (31/12/2004) are 100

What is the amount paid for salaries?

A numeric example of expenses

InterpretationSalaries expense accrued during the year is 2,000 The firm thus has not only paid all salaries of 2,000, but also paid its dues of 100

BBB Company

• Salaries expense accrued during 2004 is 2,000

• Salaries payable at the beginning of the year (1/1/2004) are 200

• Salaries payable at the end of the year (31/12/2004) are 100

What is the amount paid for salaries?

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Indirect method (*)

ƒ Net cash flows from operating is calculated from net

income, and adjusted as follows:

• (+) Depreciation is added, because it has been deducted when we

calculate net income, but there is no disbursement

• (+/-) Profits (losses) from investing and financing (such as sales of assets, debt payments) are added (subtracted), because they have been directly accounted in the category of Cash Flows from Investing and Financing

• (+/-) Changes in working capital (receivables, inventory, payables) are added (subtracted)

(*) See Lecture Notes 4a, Preparing the Statement of Cash Flows, Song Ha Company

Notes of the two methods

• The direct method provides more details of the cash

flows from operating

– Specifically and clearly shows the disbursement and

receipt flows

• The indirect method shows the “quality” of income,

and points out the factors that affect the cash flows from operating more clearly

• In both methods, cash flows from investing and

financing are prepared in the direct method

• Net cash flows in the two methods must be the same

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0 0 0

0 Total Net Cash Flows (1)

(6) (25) 10

20 Financing

(2) (10) (22)

(14) Investing

8 35 12

(6) Operating

VI III II

I

Activity

(1) Assume a zero difference between the ending and the beginning cash balances

Analysis of the statement of cash flows

Cash flows of the 4 companies, I, II, III, and IV

ª Company I is an example of a new firm or a firm

that has new products and been rapidly growing In this stage, the firm shows little profits, receivables increase (due to its credit policy) and inventory rises Net cash

flow from operating is negative (-6) because disbursements exceed receipts The firm has mobilized

so much funds (20) to serve operating and investing

(-Analysis of the statement of cash flows

Company I

0 0 0 0 Total Net Cash Flows (1)

(6) (25) 10 20 Financing

(2) (10) (22) (14) Investing

8 35 12 (6) Operating

VI III II I

Activity

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Company II reflects a firm that is longer established than

Company I; it is still in the growing stage, but its growth rate is slower It shows profits and generates positive cash flows from

operating (12) However, cash flows from operating are not sufficient to invest in PPE (-22), so it still has to mobilize funds (10)

Analysis of the statement of cash flows

Company II

0 0 0 0 Total Net Cash Flows (1)

(6) (25) 10 20 Financing

(2) (10) (22) (14) Investing

8 35 12 (6) Operating

VI III II I

Activity

Company III reflects a firm in a high and stable

development stage, generates large net cash flows from

operating (35) The firm uses the proceeds to invest in fixed

Analysis of the statement of cash flows

Company III

0 0 0 0 Total Net Cash Flows (1)

(6) (25) 10 20 Financing

(2) (10) (22) (14) Investing

8 35 12 (6) Operating

VI III II I

Activity

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Company IV reflects a picture of a firm that is going to

slow down (after reaching a peak) Net cash flows from

operating are still positive, but start to decrease (8) The

firm also reduces its investments in PPE since the industry

is slowing down (-2) It has used cash flows from operating

to pay back debt and pay dividends (-6).

Analysis of the statement of cash flows

Company IV

0 0 0 0 Total Net Cash Flows (1)

(6) (25) 10 20 Financing

(2) (10) (22) (14) Investing

8 35 12 (6) Operating

VI III II I

Activity

3,016 3,922

4,846 Beginning Cash Balance

61

2 (26)

Change in Exchange Rate

3,361 (908)

(898) Total Net Cash Flows

(7,213) (10,845)

(8,734) Net Cash Flows from Investing

INVVESTING

(5,223) (4,572)

(5,586) Net Cash Flows from Financing

FINANCING

15,797 14,509

13,422 Net Cash Flows from Operating

4,365 5,596

4,540 Adjustments of Working Capital

1,439 1,084

1,536 Depreciation

9,993 7,829

7,346 Net Income

OPERATING

2,003 2,002

2,001

(million dollars)

Fiscal Year ends on June 30

STATEMENT OF CASH FLOWS

Microsoft Corporation

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References

Horngren – Sundem – Elliott

Introduction to Financial Accounting, 8 th

Edition, Prentice Hall, 2002.

Stickney – Weil

Financial Accounting, 8 th Edition, The Dryden Press, 1997.

Nguyen Tan Binh

Ke toan quan tri, Nha xuat ban Dai hoc Quoc

gia TPHCM, 2003.